Why is working capital important?
January 14, 2016
During a recent presentation on the current state of the ag economy, Dr. David Kohl used the term "good times don't last forever, but neither do bad ones." His data basically showed that the 8 – 10 year "super cycle" is behind us and we are likely in a 3 – 5 year "reset" cycle. So what does this mean for you? It means you need to know your numbers, make good decisions, and manage your working capital well.
We hear this term working capital a lot, but what exactly is it? The equation is simply current assets minus current liabilities on your balance sheet. In more simple terms, it is the equity you have in your current assets or the amount of your short-term assets that you own (instead of the bank).
Current assets are the ones that will be sold or turned into cash in the next 12 months. For an ag producer, these would consist of grain, market livestock, feed, growing crop, prepaid inputs, and accounts receivable. Current liabilities are the offset to these assets and are how they are financed. These would include accounts payable, operating line balances, accrued interest, input financing from a vendor, as well as principal and interest payments due on your loans within the next 12 months.
So for example, if you have $500,000 in current assets and $250,000 in current liabilities, you would have $250,000 in working capital. So, if you budget that you will have $1,000,000 in expenses for the year and you have $250,000 in working capital, this means that you can pay for 25 percent of your expenses with your cash and remainder will need to come from some sort of financing.
So why is working capital so important? Basically, the stronger the working capital is, the less reliant you are on your lender and the better prepared you are to withstand tougher times. If your budget this year shows that you are going to lose money, that loss will be absorbed by your working capital. So in the example above, if you lose $50,000, it will reduce your working capital from $250,000 to $200,000. No one wants to go backwards, but that is one of the reasons to maintain strong working capital, to be prepared for just such an occasion. If you are going to lose money, you would rather lose your money than the bank's.
How you operated during the "super cycle" will likely determine how strong your working capital is right now. If you were conservative and focused on paying down debt, you likely improved your working capital. If you spent a lot of your earnings on capital purchases (land, machinery, etc.) or excessive family living expenditures (trips, 2nd homes, new cars, etc.), you used your working capital to do this. A common misconception is that if you were profitable that you "paid cash" for these items. In some cases this was true, but most likely you financed these long term assets with your short-term borrowed money (operating line) or if you did use cash, that cash was not available to cover expenses which still leads to increased short-term borrowing.
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Managing working capital is one of the many things that we focus on with our clients in the South Dakota Center for Farm Ranch Management. We analyze the financials and work with your lender to help make sure your balance sheet is structured properly. If you would be interested in working with our program to help you better track and manage your finances, please contact one of our instructors at 995-7196 or email@example.com.